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Journal of International Economics 45 (1998) 115135

How does foreign direct investment affect economic


growth? 1
E. Borensztein a , *, J. De Gregorio b , J-W. Lee c
a

International Monetary Fund, Research Department, Washington DC 20431 USA


Center for Applied Economics, Department of Industrial Engineering, Universidad de Chile,
Santiago, Chile
c
Economics Department, Korea University and NBER, Seoul 136 -701 Korea

Received 21 February 1996; received in revised form 24 February 1997; accepted 20 May 1997

Abstract
We test the effect of foreign direct investment (FDI) on economic growth in a
cross-country regression framework, utilizing data on FDI flows from industrial countries to
69 developing countries over the last two decades. Our results suggest that FDI is an
important vehicle for the transfer of technology, contributing relatively more to growth than
domestic investment. However, the higher productivity of FDI holds only when the host
country has a minimum threshold stock of human capital. Thus, FDI contributes to
economic growth only when a sufficient absorptive capability of the advanced technologies
is available in the host economy. 1998 Elsevier Science B.V.
Keywords: Foreign direct investment; Economic growth; Cross-country regression framework; Developing countries

*Corresponding author: Tel.: 11 202 6237679; Fax: 11 202 6234740; e-mail:


eborensztein@imf.org
1
We are grateful for comments from Robert Barro, Elhanan Helpman, Boyan Jovanovic, Mohsin
Khan, Se-Jik Kim, Donald Mathieson, Sergio Rebelo, Jeffrey Sachs, Peter Wickham, and two
anonymous referees. Comments by participants in seminars at 1995 World Congress of the Econometric Society, Korean Macroeconomics Workshop, Kobe University, and Osaka University were very
helpful. This paper was partially prepared while Jose de Gregorio and Jong-Wha Lee were at the
Research Department, International Monetary Fund. Any opinions expressed are only those of the
authors and not those of the institutions with which the authors are affiliated.
0022-1996 / 98 / $19.00 1998 Elsevier Science B.V. All rights reserved.
PII S0022-1996( 97 )00033-0

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E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

1. Introduction
Technology diffusion plays a central role in the process of economic
development.2 In contrast to the traditional growth framework, where technological
change was left as an unexplained residual, the recent growth literature has
highlighted the dependence of growth rates on the state of domestic technology
relative to that of the rest of the world. Thus, growth rates in developing countries
are, in part, explained by a catch-up process in the level of technology. In a
typical model of technology diffusion, the rate of economic growth of a backward
country depends on the extent of adoption and implementation of new technologies that are already in use in leading countries.
Technology diffusion can take place through a variety of channels that involve
the transmission of ideas and new technologies. Imports of high-technology
products, adoption of foreign technology and acquisition of human capital through
various means are certainly important conduits for the international diffusion of
technology.3 Besides these channels, foreign direct investment by multinational
corporations (MNCs) is considered to be a major channel for the access to
advanced technologies by developing countries. MNCs are among the most
technologically advanced firms, accounting for a substantial part of the worlds
research and development (R and D) investment. Some recent work on economic
growth has highlighted the role of foreign direct investment in the technological
progress of developing countries. Findlay (1978) postulates that foreign direct
investment increases the rate of technical progress in the host country through a
contagion effect from the more advanced technology, management practices, etc.
used by the foreign firms. Wang (1990) incorporates this idea into a model more in
line with the neoclassical growth framework, by assuming that the increase in
knowledge applied to production is determined as a function of foreign direct
investment (FDI).
The purpose of this paper is to examine empirically the role of FDI in the
process of technology diffusion and economic growth in developing countries. We
motivate the empirical work by a model of endogenous growth, in which the rate
of technological progress is the main determinant of the long-term growth rate of
income. Technological progress takes place through a process of capital deepening in the form of the introduction of new varieties of capital goods. MNCs
possess more advanced knowledge, which allows them to introduce new capital

2
Previous research on technology diffusion includes Nelson and Phelps (1966), Jovanovic and Rob
(1989), Grossman and Helpman (1991) (chapters 11 and 12), Segerstrom (1991) and Barro and
Sala-i-Martin (1995) (chapter 8).
3
See Easterly et al. (1994) for a framework incorporating the roles of technology adoption through
international trade and human capital accumulation as determinants of economic growth.!

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117

goods at lower cost.4 However, the application of this more advanced technologies
also requires the presence of a sufficient level of human capital in the host
economy. The stock of human capital in the host country, therefore, limits the
absorptive capability of a developing country, as in Nelson and Phelps (1966), and
Benhabib and Spiegel (1994). Hence, the model highlights the roles of both the
introduction of more advanced technology and the requirement of absorptive
capability in the host country as determinants of economic growth, and suggests
the empirical investigation of the complementarity between FDI and human capital
in the process of productivity growth.
We test the effect of FDI on economic growth in a framework of cross-country
regressions utilizing data on FDI flows from industrial countries to 69 developing
countries over the last two decades.5 Our results suggest that FDI is in fact an
important vehicle for the transfer of technology, contributing to growth in larger
measure than domestic investment. Moreover, we find that there is a strong
complementary effect between FDI and human capital, that is, the contribution of
FDI to economic growth is enhanced by its interaction with the level of human
capital in the host country. However, our empirical results imply that FDI is more
productive than domestic investment only when the host country has a minimum
threshold stock of human capital. The results are robust to a number of alternative
specifications, which control for the variables usually identified as the main
determinants of economic growth in cross-country regressions. This sensitivity
analysis along the lines of Levine and Renelt (1992) shows a robust relationship
between economic growth, FDI and human capital.
We also investigate the effect of FDI on domestic investment, namely, whether
there is evidence that the inflow of foreign capital crowds out domestic
investment. In principle, this effect could have either sign: by competing in
product and financial markets MNCs may displace domestic firms; conversely,
FDI may support the expansion of domestic firms by complementarity in
production or by increasing productivity through the spillover of advanced
technology.6 Our results are supportive of a crowding-in effect, that is, a one-dollar
4
It is most likely that a foreign firm that decides to invest in another country enjoys lower costs than
its domestic competitors deriving from higher productive efficiency. The higher efficiency may owe
partly to the combination of foreign advanced management skills with domestic labor and inputs.
Several micro-studies have attempted to assess empirically the impact of FDI on the domestic
economy. (See, for example, United Nations (1992), Aitken and Harrison (1993), and references
therein).
5
De Gregorio (1992) shows, in a panel data of 12 Latin American countries, that FDI is about three
times more efficient than domestic investment. Blomstrom et al. (1992) also find a strong effect of FDI
on economic growth in LDCs.
6
An additional factor could be that policies offering preferential tax treatment and other incentives to
induce inward FDI may introduce a distortion affecting domestic investment. If such distortion between
the return to foreign and domestic capital were significant, it could have a large negative effect on
growth, as in Easterly (1993).

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E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

increase in the net inflow of FDI is associated with an increase in total investment
in the host economy of more than one dollar, but do not appear to be very robust.
Thus, it appears that the main channel through which FDI contributes to economic
growth is by stimulating technological progress, rather than by increasing total
capital accumulation in the host economy.
The paper is divided into four sections. Section 2 presents a simple model to
motivate our empirical investigation; Section 3 provides an account of the data
used in the empirical analysis; Section 4 describes the regression results, and
Section 5 presents some concluding remarks.

2. An illustrative framework
We consider an economy where technical progress is the result of capital
deepening in the form of an increase in the number of varieties of capital goods
available, as in Romer (1990), Grossman and Helpman (1991) and Barro and
Sala-i-Martin (1995).7 The economy produces a single consumption good according to the following technology:
Yt 5 AH at K t1 a

(1)

where A represents the exogenous state of environment, H denotes human


capital, and K stands for physical capital. The state of environment comprises
various control and policy variables influencing the level of productivity in the
economy. We assume that human capital H is a given endowment. Physical capital
consists of an aggregate of different varieties of capital goods, and hence capital
accumulation takes place through the expansion of the number of varieties.
Specifically, at each instant in time, the stock of domestic capital is given by:
N

K5

5E

x( j)

12 a

dj

1
]]
( 12 a )

(2)

that is, total capital is a composite of a continuum of varieties of capital goods,


each one being denoted by x( j).8 The total number of varieties of capital goods is
N. There are two types of firms that produce capital goods: domestic and foreign
firms that have undertaken a direct investment in the economy. The domestic firms
produce n varieties out of the total number N, and the foreign firms produce n *
varieties:
N 5 n 1 n*
7
8

We follow closely the specification of Barro and Sala-i-Martin (1995) (chapter 6).
This formulation is due to Ethier (1982).

(3)

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119

We assume that specialized firms produce each variety of capital good, and rent
it out to final goods producers at a rental rate m( j). The demand for each variety of
capital good, x( j), follows from the optimality condition that equates the rental
rate to the marginal productivity of the capital good in the production of the final
good. This condition is:
m( j) 5 A(1 2 a )H a x( j)2 a

(4)

An increase in the number of capital varieties requires the adaptation of


technology available in more advanced countries to permit the introduction of a
new type of capital goods. We assume that this process of technology adaptation is
costly, requiring a fixed setup cost (F ) before production of the new type of capital
can take place. We assume that the fixed setup cost depends negatively on the ratio
of the number of foreign firms operating in the host economy to the total number
of firms (n * /N). This assumption is intended to capture the notion that foreign
firms bring to the developing economy an advance in knowledge applicable to
the production of new capital goods that may be already available in other
countries. Thus, by making it easier to adopt the technology necessary to produce
new capital varieties, foreign direct investment is the main channel of technological progress in this framework. In addition, we assume the existence of a
catch-up effect in technological progress to reflect the fact that it is cheaper to
imitate products already in existence for some time than to create new products at
the frontier of innovation.9 This is implemented by assuming that the setup cost
depends positively on the number of capital varieties produced domestically
compared to those produced in the more advanced countries (which we denote by
N * ). That is, in the countries with lower N /N * imitation possibilities are larger
and thus the costs of adopting new technology is lower. Thus, we postulate the
following functional form for the setup cost:
F
F
F 5 F(n * /N, N /N * ), where ]]] , 0 and ]]] . 0
(n * /N)
(N /N * )

(5)

An alternative interpretation of Eq. (5) can be given in terms of quality


ladders, as in Grossman and Helpman (1991). The increase in the number of
varieties could be interpreted as an improvement in the quality of existing goods.
If the presence of foreign firms reduces the cost of improving the quality of
existing capital goods, it will generate the same negative relationship between
foreign direct investment and setup costs. Moreover, the catch-up assumption
could be reinterpreted as meaning that the cost of improving an existing capital
good is smaller the lowest is its quality. That is, upgrading an old typewriter is
cheaper than upgrading a personal computer.
9

The importance of the technology gap as a determinant of technological diffusion has been
stressed in previous research, for example, Nelson and Phelps (1966).

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120

In addition to the fixed setup cost, once a capital good is introduced, the owner
must spend a constant maintenance cost per period of time. This is analogous to
assume that there is a constant marginal cost of production of x( j) equal to 1, and
that capital goods depreciate fully. Assuming a steady state where the interest rate
(r) is constant, profits for the producer of a new variety of capital j are:
`

P ( j)t 5 2 F(n *t /Nt , Nt /N t* ) 1 [m( j)x( j) 2 x( j)]e 2r(s 2t ) ds

(6)

Maximization of Eq. (6) subject to the demand Eq. (4) generates the following
equilibrium level for the production of each capital good x( j):
x( j) 5 HA1 / a (1 2 a )2 / a

(7)

Note that x( j) is independent of time, that is, at every instant the level of
production of each new good is the same. Moreover, the level of production of the
different varieties is also the same due to the symmetry among producers.
Substituting Eq. (7) into the demand function Eq. (4), we obtain the following
expression for the rental rate:
m( j) 5 1 /(1 2 a )

(8)

which gives the rental rate as a markup over maintenance costs.


Finally, we assume that there is free entry, and hence, the rate of return r will be
such that profits are equal to zero. Solving for the zero profits condition we obtain:
r 5 A1 / a f F(n * /N, N /N * )21 H

(9)

where

f 5 a (1 2 a )( 22 a ) / a
To close the model, we need to describe the process of capital accumulation,
which is driven by saving behaviour.10 We assume that individuals maximize the
following standard intertemporal utility function:
`

s
C 12
s
2
Ut 5 ]] e r (s 2t ) ds
12s

(10)

10

Although, for simplicity, we do not introduce international trade in this model, this is not a closed
economy because of the presence of foreign firms. However, with the proportion of foreign firms
remaining constant in a steady-state situation, equilibrium conditions are analogous to those prevailing
in a closed economy.

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121

where C denotes units of consumption of the final good Y. Given a rate of return
equal to r, the optimal consumption path is given by the standard condition:
C~
1
]t 5 ](r 2 r )
Ct s

(11)

It is easy to verify that the rate of growth of consumption must, in a steady state
equilibrium, be equal to the rate of growth of output, which we denote by g.
Finally, substituting Eq. (9) into Eq. (11), we obtain the following expression
for the rate of growth of the economy:
1
g 5 ] [A1 / a f F(n * /N, N /N * )21 H 2 r ]
s

(12)

Eq. (12) shows that foreign direct investment, which is measured by the
fraction of products produced by foreign firms in the total number of products
(n * /N), reduces the costs of introducing new varieties of capital goods, thus
increasing the rate at which new capital goods are introduced. The cost of
introducing new capital goods is also smaller for more backward countries; that is,
countries that produce fewer varieties of capital goods than the leading countriescountries with lower N /N * -enjoy lower costs of adoption of technology, and will
tend to grow faster. Furthermore, the effect of FDI on the growth rate of the
economy is positively associated with the level of human capital, that is, the higher
the level of human capital in the host country, the higher the effect of FDI on the
growth rate of the economy.
To assess empirically the effect of FDI on economic growth, we utilize the
following basic formulation:
g 5 c 0 1 c 1 FDI 1 c 2 FDI 3 H 1 c 3 H 1 c 4 Y0 1 c 5 A

(13)

where FDI is foreign direct investment, H the stock of human capital, Y0 initial
GDP per capita, and A is a set of other variables that affect economic growth. The
variable FDI is measured as a ratio to GDP, and is conceptually analogous to the
fraction of goods produced by foreign firms in the model, (n * /N).11 The initial
GDP variable (Y0 ) captures the role of the catch-up effect (N /N * ).12 The group
11

We assume that the average ratio of foreign direct investment to GDP over a decade FDI, which is
a flow variable, is a good proxy for (n * / N). Since FDI measures are available only from 1970, we can
not construct a stock measure of FDI. Also, it is not possible to differentiate between FDI in the capital
goods sector and in other sectors of the economy.
12
The theoretical model described above implies that the catch-up effect can be represented by an
interactive term between initial income and human capital (Y 0* H) in addition to the initial income (Y 0 ).
We find that when both terms are included in the regressions the interactive term (Y *0 H) is not
significant, without much effect on the overall results. However, Benhabib and Spiegel (1994) find an
interactive term in initial income and human capital to be significant for growth in a different
framework.

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E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

of variables A comprises the control and policy variables that are frequently
included as determinants of growth in cross-country studies. (See Barro and
Sala-i-Martin (1995) (chapter 12)). These variables include government consumption, the black market premium on foreign exchange, a measure of political
instability (political assassinations and wars), a measure of political rights, a proxy
for financial development, the inflation rate, and a measure of quality of
institutions.

3. Data
There are several sources for data on foreign direct investment. Two IMF
publications provide data on net and gross foreign direct investment (International
Financial Statistics, and Balance of Payments Statistics, respectively). Net FDI
refers to inflows net of outflows, and gross FDI refers only to inflows, that is,
foreign direct investment into the country. An OECD publication (Geographical
Distribution of Financial Flows to Developing Countries) tallies gross FDI
originated in OECD member countries into developing economies. The choice
between these alternatives depends on which data set would correspond more
closely to the FDI effect we are trying to uncover.
In the first place, it seems more appropriate to use gross data because we are
interested in the effects of foreign direct investment in the host country via transfer
of knowledge and other spillover effects; in addition, we would not expect the
outflow of foreign direct investment to involve a similar negative growth effects
for the source country (loss of knowledge). In the second place, in our framework,
foreign direct investment flows from industrialized to developing countries to close
the technological gap. Foreign direct investment taking place between countries
with roughly the same level of technological development may respond to a large
extent to other factors, including global firm strategy and market penetration, or to
allow firms to circumvent trade restrictions and offset other advantages accorded
to domestic producers. This type of foreign direct investment flows may not be
expected to display higher than average productivity. For this reason we focus only
on foreign direct investment received by developing countries. And furthermore,
since flows of foreign direct investment between developing countries may also
respond to factors other than the technological gap, we also exclude those flows.
Therefore, the OECD measure of foreign direct investment, while having a partial
coverage, appears to be the most appropriate for our purposes.13 These data are
available on a yearly basis from 1970.
13
Since balance of payments data from Balance of Payments Statistics do not provide information
about the country of origin, it cannot be adjusted to include flows from industrial countries only. There
are, in fact, significant differences between overall gross foreign direct investment in developing
countries and foreign direct investment originated in OECD countries (OECD data). The correlation
between these two measures, although positive, is weak (the correlation coefficient is 0.22).

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

123

National accounts data, such as the growth rate of income, initial income and
government consumption, are all taken from Summers and Heston (release 5.5 of
June 1993) which provides data up to 1989. This allows us to consider a 20-year
period for the empirical investigation. The growth rate measure is the average
annual rate of per capita real GDP over each decade, 197079 and 198089.
Government consumption is measured by the average share of real government
consumption in real GDP.
For the human capital stock variable we use the initial-year level of average
years of the male secondary schooling constructed by Barro and Lee (1993).
According to Barro and Lee (1994), this measure of educational attainment is the
one most significantly correlated with growth. Data for the other explanatory
variables, such as the domestic investment rate, the foreign exchange parallel
market premium and the measures of political instability and financial development are also taken from Barro and Lee (1994).

4. Results
The purpose of our empirical investigation is to estimate the effects of FDI on
economic growth, and to investigate the channel through which FDI may be
beneficial for growth. In particular, as discussed in Section 2, we examine whether
FDI interacts with the stock of human capital to affect growth rates. We also test
whether the level of FDI has an effect on the overall level of investment in the
country and on the efficiency of investment.
The main regression results indicate that FDI has a positive overall effect on
economic growth, although the magnitude of this effect depends on the stock of
human capital available in the host economy. However, the nature of the
interaction of FDI with human capital is such that for countries with very low
levels of human capital the direct effect of FDI is negative. The cross-country
regressions also show that FDI exerts a positive, though not strong, effect on
domestic investment, presumably because the attraction of complementary activities dominates the displacement of domestic competitors. This is an indirect
effect of FDI on growth, since it operates through pulling in other sources of
investment. All regressions are based on panel data for the two decades 197079
and 198089, and were estimated using the seemingly unrelated regressions
technique (SUR). We do not report cross-section regressions, which basically yield
the same qualitative results as those of the panel estimation. The final sample
consists of 69 developing countries, for which data on all the variables are
available.
Table 1 reveals several interesting results for the effects of FDI on economic
growth. Regression 1.1 shows that FDI has a positive impact on economic growth,
after controlling for initial income, human capital, government consumption and
the parallel market premium for foreign exchange. However, the coefficient of FDI
in this specification is not statistically significant.

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E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

Table 1
FDI and per capita GDP growth: panel of two decades (197089)
Regression number

Independent
variable
Log (initial GDP)
Schooling
Government
consumption
Log (11black
market premium)
FDI

1.1
1.2
Coefficient
(standard error)

1.3

1.4

1.5

1.6

1.7

20.0124
(0.0040)
0.0162
(0.0044)
20.0969
(0.0339)
20.0183
(0.0055)
0.6590
(0.4689)

20.0122
(0.0039)
0.0128
(0.0045)
20.0811
(0.0333)
20.0185
(0.0054)
20.8489
(0.7203)
1.6231
(0.6086)

20.0100
(0.0041)
0.0078
(0.0044)
20.0818
(0.0326)
20.0188
(0.0060)
21.0190
(0.6883)
1.3891
(0.5715)
20.0188
(0.0060)
20.0202
(0.0057)

20.0125
(0.0041)
0.0058
(0.0043)
20.0817
(0.0323)
20.0125
(0.0052)
21.3665
(0.6746)
1.6639
(0.5743)
20.0200
(0.0060)
20.0221
(0.0058)
20.0024
(0.0124)
20.0077
(0.0050)
20.0032
(0.0014)

0.0061
(0.0044)
0.0033
(0.0042)
20.0668
(0.0323)
20.0104
(0.0054)
21.4628
(0.6612)
1.6531
(0.5930)
20.0197
(0.0064)
20.0219
(0.0067)
20.0092
(0.0128)
20.0024
(0.0057)
20.0023
(0.0014)
0.0011
(0.0117)
20.0119
(0.0090)

20.0111
(0.0050)
0.0005
(0.0005)
20.0435
(0.0316)
20.0113
(0.0054)
21.8535
(0.6759)
1.6365
(0.6365)
20.0253
(0.0068)
20.0155
(0.0070)
20.0050
(0.0129)
20.0002
(0.0057)
20.0001
(0.0014)
0.0031
(0.0117)
20.0087
(0.0092)
0.0056
(0.0019)
0.39(58)
0.15(60)
1.13
(22)

FDI*schooling

20.0126
(0.0043)
0.0142
(0.0043)
20.0870
(0.0330)
20.0180
(0.0054)

1.0659
(0.3850)

Sub-Saharan
African dummy
Latin American
dummy
Assassinations
Wars
Political rights
(1 best, 7 worst)
Financial
depth
Inflation
rate
Institutions
(1 worst, 10 best)
R 2 -adjusted, individual
periods (No. of obs.)
Education threshold
(No. countries.threshold)

0.28(69)
0.08(69)

0.32(69)
0.10(69)

0.33(69)
0.08(69)
0.52
(46)

0.34(69)
0.23(69)
0.73
(38)

0.37(69)
0.19(69)
0.82
(32)

0.32(64)
0.21(67)
0.89
(29)

Notes: The system has 2 equations, where the dependent variables are the per capita GDP growth rates over each decade. Each equation
has a different constant term (not reported)b . Other coefficients are constrained to be the same for all periods. Estimation is by the SUR
technique. The estimation allows for different error variances in each equation and for correlation of these errors across equations.
Education threshold indicates that countries with secondary schooling above this threshold will benefit positively from FDI. The number
of countries that satisfy it in 1980 for each regression is in the parenthesis.

Including the interaction between FDI and human capital improves the overall
performance of the regression. The specification in regression 1.2 replaces the FDI
variable by the product between FDI and human capital, and yields a coefficient
that is positive and highly statistically significant. While this specification follows

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

125

fairly closely the framework developed in Section 2, the significance of the


interaction term may be the result of the omission of other relevant factors, in
particular, the FDI variable by itself. Thus, it is necessary to include FDI and
secondary school attainment (our measure of human capital) individually alongside
their product. In that way, we can test jointly whether these variables affect growth
by themselves or through the interaction term. Such specification is adopted in
regression 1.3, which shows that the coefficient on FDI is negative, although
insignificant, while the interaction term is positive. The values of these regression
coefficients indicate that all countries with secondary school attainment above 0.52
will benefit positively from FDI.14 In our sample, 46 out of the 69 countries satisfy
this threshold in 1980. Hence, for example, in an economy with a human capital
stock of 0.91 years-which is the average value of the sample countries in 1980-an
increase of 0.005 in the FDI-to-GDP ratio (equivalent to one standard deviation)
raises the growth rate of the host economy by 0.3 percentage points per year.
We have also explored the interaction of FDI with indicators of distortions in
the trade regime, as measured by tariffs, and in the capital account of the balance
of payments, which was proxied by the parallel market premium for foreign
exchange.15 In both cases, however, the interaction term was not statistically
significant. Thus, this type of distortion does not appear to have affected the nature
of FDI flows in a significant way, at least as far as can be detected in this sample.
We also incorporated in the regression an interaction term between human capital
and initial income as suggested by the model, where the speed of convergence is
increasing in the level of human capital, but the coefficient was not significant.
Regressions 1.4 to 1.7 include additional variables proxying for the other factors
affecting economic growth. Regression 1.4 includes continental dummies for the
African and Latin American countries. Regression 1.5 includes variables that
measure political instability, such as per capita political assassinations per year, a
dummy for wars on the national territory, and a measure of political rights. The
measure of political rights is a subjective index for freedom of speech and the
press, freedom to run for office and vote in each country, obtained from Gastil
(1987) and other issues. In regression 1.6 we also controlled for the level of
financial development and the inflation rate. Financial development is proxied by
the ratio of the liquid liabilities of the financial system to GDP, which for most
countries equals M2 / GDP. King and Levine (1993) show that this measure is
closely associated with long-run growth. Finally, regression 1.7 includes a measure

14
Meaning a male population above 25 years with an average of 0.52 years of secondary schooling.
An example of an economy with secondary school attainment of 0.52 is the following: only 10 percent
of the population above 25 years of age has ever attended secondary school; out of this group, only 75
percent completed secondary school (6 years), with the remaining going only through the first cycle (3
years). Then, secondary school attainment is 0.103[330.251630.75]10.93050.53.
15
We have also included the average level of tariffs as one of the regressors, but it was not
significantly different from zero.

126

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

of quality of institutions from Knack and Keefer (1995). This measure is an


average of Knack and Keefers measures of quality of political institutions from
the International Country Risk Guide of (a) government repudiation of contracts,
(b) risk of expropriation, (c) rule of law, and (d) bureaucratic quality. Our main
findings are robust to the inclusion of these other determinants of growth. In all
cases, the interaction term between FDI and human capital is statistically
significant, implying that the estimated effect does not result from the omission of
other policy variables. However, the threshold for the value of the measure of
human capital from which FDI starts having positive effects tends to increase as
more additional variables are added to the basic regressions, and reaches a
maximum value of 1.13 years, as reported in the last line of Table 1. In addition,
as expected, the parallel market premium and the African and Latin American
dummies enter with statistically significant negative coefficients, while the
institutional quality is positively correlated with growth. In contrast, the measures
of political instability, financial development, and the inflation rate turn out to be
insignificant, which diverges from previous findings.16
Overall, the results from the regressions displayed in Table 1 show strong
complementary effects between FDI and human capital on the growth rate of
income. This result is consistent with the idea that the flow of advanced
technology brought along by FDI can increase the growth rate of the host economy
only by interacting with that countrys absorptive capability. It is, however,
puzzling that most specifications yield a negative coefficient for the FDI variable,
with the implication that FDI makes a negative contribution to growth in countries
with a low level of human capital. One could go as far as accepting that FDI
makes no additional contribution to economic growth but it is hard to conceive
situations in which, if the country has a very low stock of human capital, FDI
would actually detract from economic growth. Most likely, the estimates result
from the linearization of what is probably a nonlinear interaction between FDI and
human capital. That is, it is likely that at very low levels of human capital the
contribution of FDI to growth is close to nil and that it rises rapidly at higher
levels of human capital. However, a linear least squares estimation of this function
yields a negative intercept (at zero level of human capital). Nevertheless, the
estimated effect of FDI on growth may be approximately correct for countries with
nearly average values of human capital.17

16

One reason why the measures of political instability, financial development and inflation rates are
insignificant in the regressions may be that the sample used in our regressions includes only developing
countries.
17
The estimation of a general nonlinear functional form is not a promising prospect, however. This
would require to add higher order terms not only for the variables (such as FDI squared and schooling
squared) but also for the interaction terms (such as FDI times schooling squared, etc.). This would not
only reduce the degrees of freedom in the estimation but also probably cause significant multicollinearity problems.

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

127

The complementarity of FDI and schooling is illustrated in Fig. 1. The sample


of 69 developing countries was divided into nine (333) groups according to the
level of FDI and of human capital (measured by educational attainment). Countries
in the group with the highest levels of FDI and human capital grew, on average, by
4.3 percent a year during the sample period 197089. In contrast, countries at the
other end of the spectrum, those with the lowest levels of FDI and human capital
grew only by 0.64 percent per year on average. The figure also shows that, for a
given level of human capital, an increase in FDI raises the growth rates of per
capita income, except for the economies with the lowest level of schooling.
It is noteworthy that other studies-with somewhat different focus-have also
found an interaction effect between foreign financing and the level of human
capital in the domestic economy. Cohen (1993) finds a positive interaction
between human capital and the overall access to foreign financing of developing
countries. Our model may, in fact, provide a rationale for his finding, at least as far
as the FDI component of foreign financing is concerned. Romer (1993) finds a
positive effect on economic growth from the interaction between secondary school
enrolment and imports of machinery. He also finds a minimum threshold level for
the interaction term to have a positive impact on growth. While imports of
machinery and equipment may be one channel for the international transmission of

Fig. 1. Foreign Direct Investment, Schooling and Growth

128

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

technological advances, FDI has probably an even larger role, as it also allows the
transmission of knowledge on business practices, management techniques, etc.

4.1. Does FDI crowd out domestic investment?


To further investigate the contribution of FDI to economic growth, we analyze
its relationship with total investment. FDI could add economic growth simply by
augmenting capital accumulation in the host country. This would require that FDI
does not crowd out equal amounts of investment from domestic sources by
competing in product markets or financial markets (for example, under conditions
of financial repression). In addition, FDI could increase economic growth if it is
more productive, or efficient, than domestic investment.
To investigate these issues, we first analyze the effects of FDI on total fixed
investment. Table 2 presents an estimation of the determinants of total fixed
investment. Regressions 2.1 to 2.4 show that FDI increases total investment more
than one for one. Since data on total investment include FDI, a coefficient equal to
one would imply that FDI does not affect the total level of investment. The
coefficients on FDI range from 1.5 to 2.3 according to the particular specification,
and imply that FDI actually stimulates, or crowds in domestic investment.18 The
interaction between FDI and human capital, however, turns out to be statistically
insignificant for the determination of total investment (regression 2.2), suggesting
that the complementarity between foreign and domestic investment is not sensitive
to the productivity of FDI.
The complementarity between domestic and foreign investment, however, is not
very robust to different specifications. Except for the baseline specification, the
estimated coefficients are statistically insignificant. While multicollinearity and the
overall poorer fit of the fixed investment regressions may account for the lack of
robustness of the crowding-in effect, this result suggests that most of the effect of
FDI on growth probably derives from efficiency gains rather than an overall higher
induced level of investment.

4.2. Is FDI more efficient than domestic investment?


To explore the possibility of higher efficiency of FDI, we test whether FDI has
effects over and above those of aggregate investment in the growth equations.
Table 3 presents the growth rate regressions that control for total fixed investment
in addition to the other determinants of growth. The results do not differ
qualitatively from those obtained without the inclusion of total fixed investment.
The contribution of FDI to growth is evident only when the interaction between
human capital and FDI is included. However, the requirements on human capital
18

This would be the case, for example, if FDI stimulated investment in activities that are
complementary to the projects undertaken by the foreign firms.

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

129

Table 2
FDI and aggregate investment rates: panel of two decades (197089)
Regression number
Independent
variable
Log(initial GDP)
Schooling
Government
consumption
Log(11black
market premium)
FDI

2.1
2.2
Coefficient
(standard error)

2.3

2.4

2.5

2.6

0.0346
(0.0102)
0.0197
(0.0109)
20.1217
(0.0876)
20.0078
(0.0118)
2.2944
(0.9919)

0.0356
(0.0105)
0.0045
(0.0105)
20.1367
(0.0843)
20.0071
(0.0105)
1.5257
(0.9367)

0.0361
(0.0108)
0.0042
(0.0106)
20.1276
(0.0869)
20.0072
(0.0010)
1.5477
(0.9456)

0.0324
(0.0115)
0.0007
(0.0106)
20.1256
(0.0902)
20.0129
(0.0116)
1.2641
(0.9367)

0.0291
(0.0128)
0.0043
(0.0114)
20.1224
(0.0905)
20.0083
(0.01155)
0.7833
(0.9442)

20.0647
(0.0172)
20.0647
(0.0158)

20.0653
(0.0177)
20.0626
(0.0166)
20.0103
(0.0229)
0.0027
(0.0102)
0.0006
(0.0033)

20.0454
(0.0181)
20.0426
(0.0185)
20.0228
(0.0226)
0.0160
(0.0103)
20.0016
(0.0033)
0.0252
(0.0249)
20.0364
(0.00151)

20.0449
(0.0197)
20.0332
(0.0186)
20.0186
(0.0222)
0.0166
(0.0102)
20.0006
(0.0034)
0.0148
(0.0248)
20.0389
(0.0151)
0.0111
(0.0055)
0.17(58)
0.55(60)

FDI*schooling

0.0344
(0.0101)
0.0210
(0.0113)
20.1283
(0.0887)
20.0080
(0.0117)
2.8230
(1.6257)
20.5165
(1.2926)

Sub-Saharan
African dummy
Latin American
dummy
Assassinations
Wars
Political rights
(1 best, 7 worst)
Financial
depth
Inflation
rate
Institutions
(1 worst, 10 best)
R 2 -adj, individual
periods (No. of obs.)

0.23(69)
0.44(69)

0.22(69)
0.43(69)

0.26(69)
0.55(69)

0.21(69)
0.53(69)

0.17(64)
0.51(67)

Notes: The system has 2 equations, where the dependent variables are the average ratios of investment
to GDP over each decade. See note to Table 1.

are higher compared to those reported in Table 1. In the basic regression 3.3, the
values of the coefficients (21.461 for FDI and 1.647 for the interaction term)
imply that the threshold level of education for which the effects of FDI turn
positive is 0.88, which is satisfied by 29 countries in the sample. Note, however,
that countries with school attainment below 0.88 would still benefit from FDI if
the crowding-in effect on domestic investment were significant. For example,
taking a value of 1.5 for the crowding-in coefficient-close to the average of the
point estimates in Table 3-and using the parameter values estimated in regression

130

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

Table 3
Per capita GDP growth: productivity of FDI and domestic investment
Regression number

Independent
variable
Investment rate
Log (initial GDP)
Schooling
Government
consumption
Log(11black
market premium)
FDI

3.1
3.2
Coefficient
(standard error)

3.3

3.4

3.5

3.6

3.7

3.8

0.1403
(0.0320)
20.0167
(0.0038)
0.0133
(0.0041)
20.0840
(0.0306)
20.0169
(0.0051)
0.0605
(0.4535)

0.1415
(0.0307)
20.0165
(0.0036)
0.0098
(0.0041)
20.0663
(0.0299)
20.0165
(0.0049)
21.4607
(0.6728)
1.6473
(0.5555)

0.1422
(0.0425)
20.0165
(0.0037)
0.0100
(0.0087)
20.0664
(0.0300)
20.0166
(0.0050)
21.4639
(0.6796)
1.6520
(0.5818)
20.0010
(0.0411)

0.1120
(0.0317)
20.0137
(0.0040)
0.0069
(0.0040)
20.0711
(0.0303)
20.0155
(0.0047)
21.4928
(0.6581)
1.4953
(0.5415)

0.1028
(0.0311)
20.0157
(0.0040)
0.0052
(0.0040)
20.0719
(0.0305)
20.0120
(0.0050)
21.7599
(0.6496)
1.7197
(0.5476)

0.0923
(0.0304)
20.0090
(0.0043)
20.0031
(0.0039)
20.0612
(0.0304)
20.0098
(0.0052)
21.7933
(0.6398)
1.7101
(0.5665)

0.0880
(0.0323)
20.0120
(0.0048)
20.0013
(0.0048)
20.0375
(0.0299)
20.0100
(0.0051)
22.2058
(0.6645)
1.8858
(0.6132)

20.0124
(0.0058)
20.0142
(0.0055)

20.0166
(0.0057)
20.0199
(0.0062)
20.0022
(0.0120)
20.0067
(0.0049)
20.0028
(0.0013)

20.0154
(0.0062)
20.0186
(0.0064)
20.0071
(0.0124)
20.0025
(0.0055)
20.0020
(0.0013)
20.0041
(0.0112)
20.0098
(0.0087)

20.0218
(0.0065)
20.0154
(0.0066)
20.0039
(0.0124)
0.0002
(0.0056)
20.0002
(0.0014)
20.0020
(0.0113)
20.0067
(0.0089)
0.0042
(0.0019)
0.40(58)
0.19(60)
1.10
(23)

FDI*schooling

0.1279
(0.0309)
20.0169
(0.0037)
0.0124
(0.0040)
20.0781
(0.0301)
20.0160
(0.0050)

0.7324
(0.3658)

Investment rate*
schooling
Sub-Saharan
African dummy
Latin American
dummy
Assassinations
Wars
Political rights
(1 best, 7 worst)
Financial
depth
Inflation
rate
Institutions
(1 worst, 10 best)
R2-adj, individual
periods (no. of obs.)
Education threshold
(No. countries.threshold)

0.41(69)
0.13(69)

0.41(69)
0.17(69)

0.44(69)
0.16(69)
0.76
(36)

0.43(69)
0.15(69)
0.76
(36)

0.43(69)
0.23(69)
0.88
(29)

0.44(69)
0.20(69)
0.93
(29)

0.38(64)
0.22(67)
0.97
(29)

Note: See Table 1.

3.3, the threshold value of human capital becomes 0.76 years of post-primary
education, which is satisfied by 36 countries in the sample.
In order to investigate whether the interaction effect is unique to foreign
investment, or it applies to investment from all sources, we have also added an

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

131

interaction term between aggregate investment and secondary school attainment.


In regression 3.4, the interaction term between aggregate investment and human
capital is not statistically significant, while the rest of the coefficients are very
similar to those obtained in specifications in which this term is not included. The
same result obtains when the interaction term between domestic investment and
secondary schooling is included in the other specifications reported in Tables 3 and
4. Therefore, we can conclude that the interaction between human capital and
investment is a particular characteristic of FDI.
The above result may be indicative of differences in the technology involved in
foreign direct investment. FDI may primarily flow to sectors where a process of
technological innovation similar to that described in the model of Section 2 is
present, and thus the interaction with human capital is an important factor in
explaining the effects of FDI in economic growth. By contrast, domestic
investment may largely fall on more traditional activities, and thus the interaction
effect between aggregate fixed investment and human capital may not be
sufficiently large to be detected in the regressions.
Regressions 3.5 to 3.8 include the additional determinants of economic growth,
such as continental dummies, political variables, financial development, the
inflation rate and the quality of institutions. The interaction term between FDI and
human capital is always statistically significant, irrespective of the specifications.
The inclusion of more additional variables into the basic regressions raises the
threshold stock for secondary schooling, reaching a maximum value of 1.10 years
(including the crowding-in effect) in regression 3.8, which is satisfied by 23
countries in the sample.19

4.3. Endogeneity problems?


It should be noticed that the cross-country regressions presented here may be
subject to endogeneity problems. The correlation between FDI and growth rate
could arise from an endogenous determination of FDI, that is, FDI itself may be
influenced by innovations in the stochastic process governing growth rates. For
instance, any omitted factors that raise the rate of return on capital will also
increase both the growth rate and the inflow of foreign direct investment
simultaneously.20 In these circumstances there would exist a correlation between
FDI and the country-specific error term, which would bias the estimated
coefficients.
19

We also tested the robustness of the results to the effect of possibly influential observations in the
form of those countries that have received the highest levels of FDI. The results (available from the
authors) of regressions excluding the seven countries which received the highest levels of FDI over the
sample period are very similar to those obtained for the whole sample, with threshold levels of human
capital increasing only marginally.
20
See Edwards (1990) for a discussion on the determination of foreign direct investment in LDCs.

132

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

Table 4
FDI and per capita growth: instrumental variables estimation
Regression number

Independent
variable

4.1
4.2
Estimation method

4.3

4.4

4.5

4.6

4.7

4.8

4.9

3SLS
3SLS
Coefficient
(standard error)

3SLS

3SLS

3SLS

3SLS

3SLS

2SLS

2SLS

20.0115
(0.0042)
0.0055
(0.0044)
20.0848
(0.0326)
20.0127
(0.0052)
21.7086
(0.8001)
1.5522
(0.6344)
20.0206
(0.0060)
20.0240
(0.0060)

0.1094
(0.0315)
20.0150
(0.0040)
0.0051
(0.0040)
20.0743
(0.0306)
20.0122
(0.0050)
22.0461
(0.7649)
1.6031
(0.6043)
20.0142
(0.0058)
20.0177
(0.0058)

20.0106
(0.0050)
20.0007
(0.0052)
20.0416
(0.0319)
20.0111
(0.0054)
22.4322
(0.7902)
1.7039
(0.7092)
20.0256
(0.0069)
20.0164
(0.0070)

0.0934
(0.0329)
20.0116
(0.0048)
20.0025
(0.0050)
20.0346
(0.0305)
20.0094
(0.0051)
22.6497
(0.7680)
2.0154
(0.6880)
20.0217
(0.0066)
20.0164
(0.0067)

0.0791
(0.0576)
20.0084
(0.0058)
20.0023
(0.0074)
20.0224
(0.0483)
20.0046
(0.0056)
21.8619
(1.7948)
1.8156
(1.1105)
20.0074
(0.0083)
20.0305
(0.0081)

0.1493
(0.0697)
20.0032
(0.0072)
20.0104
(0.0083)
0.0450
(0.0551)
0.0011
(0.0063)
24.1850
(1.8170)
3.5432
(1.2132)
20.0140
(0.0102)
20.0298
(0.0096)

20.0039
(0.0123)
20.0006
(0.0056)
20.0002
(0.0014)
20.0015
(0.0117)
20.0062
(0.0088)
0.0045
(0.0019)
0.38(58)
0.20(60)
1.24
(15)

0.0054
0.0130
(0.0127) (0.0145)
0.0108
0.0166
(0.0063) (0.0074)
20.0047 20.0027
(0.0018) (0.0020)
20.0188
(0.0170)
20.0110
(0.0098)
0.0022
(0.0031)
0.38(69) 0.36(60)

Investment rate
Log(initial GDP)
Schooling
Government
consumption
Log(11black
market premium)
FDI
FDI*schooling
Sub-Saharan
African dummy
Latin American
dummy
Investment*
schooling
Assassinations

20.0092
(0.0042)
0.0071
(0.0045)
20.0814
(0.0329)
20.0166
(0.0050)
21.4575
(0.8253)
1.4791
(0.6314)
20.0191
(0.0060)
20.0214
(0.0058)

0.1177
(0.0324)
20.0133
(0.0040)
0.0064
(0.0041)
20.0705
(0.0305)
20.0156
(0.0047)
21.8272
(0.7875)
1.5307
(0.5972)
20.0122
(0.0058)
20.0150
(0.0055)

Wars
Political rights
(1 best, 7 worst)
Financial
depth
Inflation
rate
Institutions
(1 worst, 10 best)
R 2 -adj, individual
periods (no. of obs.)
Education threshold
(No. countries.threshold)

0.34(69)
0.22(69)
0.99
(28)

0.43(69)
0.23(69)
1.08
(26)

0.1237
(0.0421)
20.0138
(0.0040)
0.0099
(0.0085)
20.0707
(0.0302)
20.0159
(0.0047)
21.5369
(0.6625)
1.5589
(0.5598)
20.0124
(0.0058)
20.0146
(0.0056)
20.0166
(0.0403)

20.0019 20.0017 20.0048


(0.0125) (0.0121) (0.0130)
20.0088 20.0027 20.0004
(0.0051) (0.0013) (0.0058)
20.0031 20.0027 20.0001
(0.0014) (0.0013) (0.0014)
0.0054
(0.0120)
20.0079
(0.0093)
0.0063
(0.0020)
0.43(69) 0.38(69) 0.45(69) 0.39(58)
0.21(69) 0.18(69) 0.18(69) 0.14(60)
0.87
1.10
1.17
1.43
(29)
(23)
(20)
(13)

0.96
(29)

1.12
(23)

Note: three-stage least squares (3SLS) estimation was done on a system of two equations for the periods 197079 and 198089, using as
instruments: the lagged value of FDI, the log value of total GDP, the log value of area, and continental dummies for East Asia and South
Asia. The two-stage least squares (2SLS) estimation was done on the cross-section of countries for the period 198089 using the same
instruments.

E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

133

Although, in principle, the endogeneity problem can be avoided by applying


instrumental variable techniques, the fundamental problem is that there are no
ideal instruments available. A good instrument would be a variable which is highly
correlated with FDI but not with the error term in these regressions. Nevertheless,
we have tried to control for the endogeneity problem by using as instruments the
lagged values of FDI, a log value of total GDP, a log value of area, continental
dummies for East Asia and South Asia, and the measures of political stability and
quality of institutions, and the other explanatory variables in the regressions.
The results of this instrumental variable estimation are reported in Table 4.21
Regressions 4.1 to 4.7 show that the instrumental variable estimation yields
qualitatively similar results to those obtained by SUR estimation. The estimated
coefficients on FDI are still significantly negative, and the interactive term with
human capital is significantly positive. The requirements on human capital,
however, are more stringent as they typically imply a minimum of just over one
year of post-primary education. We also carried out the instrumental variable
estimation on a cross-sectional sample for the second decade, 198089, which is
reported in regressions 4.8 and 4.9. In this case, we used the value of FDI over the
first decade, 197079 and other instruments for the two-stage least squares
estimation. The coefficients on the FDI and the FDI interactive terms show a
similar qualitative pattern.

5. Conclusions
There is a good a priori case to presume that FDI is more productive than
domestic investment. As Graham and Krugman (1991) argue, domestic firms have
better knowledge and access to domestic markets; if a foreign firm decides to enter
the market, it must compensate for the advantages enjoyed by domestic firms. It is
most likely that a foreign firm that decides to invest in another country enjoys
lower costs and higher productive efficiency than its domestic competitors. In the
case of developing countries in particular, it is likely that the higher efficiency of
FDI would result from a combination of advanced management skills and more
modern technology; FDI may be the main channel through which advanced
technology is transferred to developing countries.
Different types of economic distortions, however, may jeopardize the role of
FDI as a means for advanced technology transfer. For example, because of
protectionist trade policies, FDI may be the only way to gain access to domestic
21

Because the data on FDI are available only from 1970, we have used the initial value of FDI over
the period 197072 as an instrument for the first decade. For the second decade, the lagged value of
FDI over the period 197580 was used as an instrument. The rationale for the inclusion of total GDP
and country area as instruments is that they represent the effect of market size and of the abundance of
natural resources, respectively, which have been often mentioned as important determinants of FDI in
previous literature.

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E. Borensztein et al. / Journal of International Economics 45 (1998) 115 135

markets by firms that would otherwise have been exporters to the host country.
Similarly, governments may offer a set of incentives to foreign investors to
stimulate the inflow of FDI, with the objective of increasing foreign exchange
reserves or of developing certain sectors considered strategic from an industrial
policy viewpoint. These policies may result in a flow of FDI that does not respond
to higher efficiency but only to profit opportunities created by distorted incentives.
These considerations make the empirical evaluation of the performance of FDI an
appealing question. We investigated these issues in a sample that comprises FDI
flows from industrial country into developing countries
The most robust finding of this paper is that the effect of FDI on economic
growth is dependent on the level of human capital available in the host economy.
There is a strong positive interaction between FDI and the level of educational
attainment (our proxy for human capital). Notably, the same interaction is not
significant in the case of domestic investment, possibly a reflection of differences
of technological nature between FDI and domestic investment. We also found
some evidence of a crowding-in effect, namely that FDI is complementary to
domestic investment. This effect, however, seems to be less robust than our other
findings.
Some caution must be exercised, however, in the interpretation of the size of the
effect on economic growth of FDI. Our data measures the international flow of
resources for foreign direct investment, as recorded in balance of payments
statistics. This is, however, only part of the resources invested by a multinational
firm, because some part of the investment may be financed through debt or equity
issues raised in the domestic market. Thus, our measure of FDI underestimates the
total value of fixed investment made by a multinational firm and the coefficients
on FDI may be proportionally overestimated. To the extent that this bias in the
measure of FDI is uniform across countries and over time, the qualitative results
are not affected.
Finally, the results of this paper suggest some directions for further research.
The results suggest that the beneficial effects on growth of FDI come through
higher efficiency rather than simply from higher capital accumulation. This
suggests the possibility of testing the effect of FDI on the rate of total factor
productivity growth in recipient countries. In addition, given the robustness of the
effect of interactions between human capital and FDI, it might be interesting to
explore the effects of FDI on the level of human capital. As we have argued
above, FDI is a vehicle for the adoption of new technologies, and therefore, the
training required to prepare the labour force to work with new technologies
suggests that there may also be an effect of FDI on human capital accumulation.

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